Dissecting the Convergence of the Securities Markets and the Commodities Markets Regulators

[The following guest post is contributed by Abhilasha Mondal, a 5th year
student at the National Law School of India University, Bangalore. She can be
contacted at [email protected]]

The Finance
Bill, 2015-16, actualises the merger between the Securities and Exchange Board
of India (“SEBI”) and the Forward Markets Commission
(“FMC”). The unification of
the regulators, that has been previously recommended in the Report
of the Inter-Ministerial Task Force on Convergence of Securities and Commodity
Derivative Markets (2003), the Percy Mistry Committee Report (2007), the
Raghuram Rajan Committee Report (2009) and the Financial Sector Legislative
Reforms Commission Report (2013), will finally materialize once the Bill has
been passed by the Parliament.

Parts II Part
III of the Finance Bill aim to give effect to the merger, by introducing
amendments to the respective statutes governing the securities market and the
commodity derivatives markets.

By an
amendment to the Forward Contracts (Regulation) Act, 1952 (“FCRA”), a
new savings clause by way of section 28A has been introduced which states that
all recognised associations under the FCRA shall be deemed to be recognised
stock exchanges under the Securities Contracts (Regulation) Act, 1956, (“SCRA”).
SEBI will give these exchanges adequate time to comply with the SCRA. The amendment
also provides for the repeal of the FCRA and all the rules and regulations
framed, and the dissolution of all bodies established thereunder. All fresh
proceedings with respect to the offences under the FCRA will be initiated
before SEBI.

Under the SCRA, the Bill will amend the definition of securities under Section 2(ac) to
include commodity derivatives and forward trading within its ambit. Additionally,
an amendment to Section 18A will empower the Central
Government to notify certain contracts as derivatives.

In effect, the securities market
regulator, SEBI will now supervise all regional and national commodity
exchanges. The guidelines issued by the FMC will remain in effect for a period
of one year or till its merger with SEBI, whichever is earlier.

Market experts believe that
regulation of commodity derivatives trading requires specialized knowledge for
the reason that factors affecting commodity prices are highly complex and
commodity specific. The Report of the
Inter-Ministerial Task Force on Convergence of Securities and Commodity
Derivative Markets lists out some of these
divergences between the securities market and the commodities markets.

Firstly, financial futures are
actively traded in cash markets, due to which its cash prices are usually not
discoverable in the futures market. Future contracts, instead, are generally
settled from cash or indexes of cash price. The delivery and settlement
processes among the two segments differ significantly. Exchanges monitor
contract expiration, set the terms of delivery, oversee physical delivery and
credit verification of members, and provide financial services such as clearing,
delivery, margining and trading. However, in derivatives transactions, delivery
and oversight is less significant, and it can be substituted by cash
transactions and other institutional arrangements.

Secondly, it is feared that
segments such as agricultural commodities would lose focus in the enormous web
of financial products that fall under the securities exchanges. Willing
participants feel the impact of price volatility in the stock markets, as opposed
to in the commodities market, where the impact of price volatility is felt
across the country due to the sharp fluctuation in the respective commodities’
prices. The utmost priority of the policy makers must be to safeguard the
interests of the farmers and consumers.

Thirdly, removing restrictions
on the integration of the two markets may have adverse impacts on the viability
of smaller exchanges that have been recently granted in principle approval. These
exchanges, which have incurred massive investment expenses on infrastructure,
may not be able to penetrate the commodities segment immediately, once the amendment
is in effect. The larger exchanges will be able to benefit from these
regulatory changes due to their economies of scale.

Approaches to Integration

Presently,Regulation 8
of the Securities Contracts (Regulation) Rules, 1957 (“SCRR”)
restricts stock-brokers to operate simultaneously in the commodity markets and
securities markets.To overcome this restriction, a stock-broking entity
will have to set up a separate and independent entity that can be registered to
function under the commodity exchange. Both these entities will be required to
comply with the regulatory prescriptions on capital adequacy, margins,
membership, net worth, etc. of their respective regulators and exchanges. The
rationale behind the requirement of independent entities is to ensure that risk
in one market does not have a cascading effect on other markets. The prevention
of systemic risk, in case of failure in one segment, is the root of this
regulation.

The Report of the
Inter-Ministerial Task Force provided a brief description of the various models
for the integration of the securities market and the commodity derivatives
market. One of the models described was Integration at the Level of
Brokerage Firms, which
deals with the possibility of brokers to operate, simultaneously, in the
commodities as well as the securities markets. The Bill, that will now
permit exchanges to trade in both commodity derivatives and securities, will
have the effect of permitting brokers to trade in both the products
simultaneously, without having to set up two independent entities.

Implications of the Merger

The SEBI-FMC merger has implications from an economic and
a regulatory standpoint. The economic advantages of the merger include the
fungibility of exchanges and intermediaries to penetrate into each other’s
market segments. This fungibility is expected to improve the overall quality of
institutions and intermediaries, promote competition, increase returns at low
incremental costs, provide greater choice in investments to investors, and
enhance liquidity in the markets. The merger sounds a death knell for dabba-trading activities, which are illegal off-market trades, which
are said to generate a turnover of around 1 lakh crore in a day. Trading volumes in commodity
markets are also expected to increase due to the boost in investor confidence,
because of the substitution of the extant framework with that of SEBI’s
discerningly effective regulatory presence.

Although the SEBI-FMC merger
has elicited much market euphoria, a plethora of new-fangled concerns regarding
the regulation of commodity derivatives have surfaced. SEBI presently does not
have the specialized knowledge or expertise to supervise and monitor the
commodities market. Unlike the deliveries of bonds and shares, the deliveries
of commodities are physical in nature. When the merger was previously proposed
in 2009, the then FMC Chairman, B.C. Khatua had commented on the impracticality
of the same, because he believed that the motivations driving the two
regulators were different. SEBI played a pure regulatory role, whereas the
market conditions of the commodity derivatives were such, that the FMC had
grown undertake more of a developer-cum-regulator role. The task of SEBI was to
mobilize capital for investment, while on the other hand the FMC was in charge
of managing price risk and price discovery. The merger would thus have a
diluting effect on the commodities market.

Khatua also pointed out that
at par regulatory treatment of commodity derivatives and securities had
backfired in the West, and could pose dangers in the commodities market. The
sharp increase in crude oil future prices had transcended onto the price of the
underlying commodities, which had resulted in the destabilizing of the global
economy in 2009.

Markets experts anticipate the
emergence of new products with the bringing of commodity derivatives under the
definition of securities. Investors
might now be able to subscribe for instruments such as commodity options and
commodity indices that were previously not offered. There is much speculation
whether fund houses will be permitted to launch commodity funds. Additionally,
subject to the approval of the Central Government, sports, weather or freight
derivatives may be introduced in the markets.

It is imperative at this stage
to acknowledge all these issues that will materialise at the instance of the
merger. To address the above mentioned challenges, SEBI will have to issue
regulations, guidelines or clarifications with respect to the regulation of
commodity derivatives, and plug the plausible loopholes with respect to new
financial products that may see the light of day, to ensure that such products
do not escape regulatory oversight.

Ancillary to the regulatory
impediments, an administrative decision will have to be taken as to whether
SEBI must alter its organizational and regulatory framework and create a
separate segment for commodity derivatives, or whether the regulatory
prescriptions applicable to securities will now be extended to commodities
derivatives with appropriate exceptions.

Besides the regulatory and
administrative concerns, the economic argument against the merger is the
increased risk factor in affording integration of markets at the level of
brokerage firms. Subsequent to the merger,
securities exchanges and commodities exchanges will have the fungibility to
penetrate into each other’s markets. This denotes that a commodity exchange can
facilitate currency derivatives or equity trading, whereas a securities
exchange will now be permitted to launch commodity trading. The same fungibility will be afforded between
clearing corporations and depositories.Therefore a stock-broker does
not have to set up a separate entity to trade in commodity derivatives. As
discussed earlier, the rationale behind Regulation 8 of the SCRR was risk
containment and minimizing the possibility of systemic risk across the markets.
After the merger, the collapse of a systemically important broker in one market
might send shock waves in all those market segments in which that broker has a
presence.

The dynamics
of the commodities market will have to be studied in depth by the securities
regulator to grasp the nuances of the sector. SEBI has a long way to go in the
time window imposed by the Central Government, and must bring clarity in the
regulatory environment, which is vital to the success and stability of Indian
capital markets.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

3 comments

IMPROMPTUDerivative of the word ’dissect’, it appears, has been fittingly chosen. For, the write-up makes for an attempt to simply ‘cut open’ the Budget proposal, which seeks to give effect to the idea mooted years before, of unification ( or is it merger ?) of SEBI and FMC, governed for long by two different enactments and functioning independently and exclusively . And, understandably, stops short of embarking on the most arduous and mindboggling step / exercise of ‘examination’ of the intricacies of the scheme of things as proposed. Be that as could not have been expected otherwise, as of now, anyone,- except, perhaps, those few having an intimate or reasonable familiarity with the contents of the mentioned expert committees’ Reports, is sure to have been left nonplussed; and bewildered as to how, as wished by the writer, the utmost priority in the mind of the policy makers could have been to in the ultimate analysis, safeguard (keep protected !) the interests of the two immediately-going-to-be impacted classes, -farmers and consumers; let alone the rest of the populace, also having the most concern for the wholesome economic welfare of the nation.Left to keep looking ahead, for an educative enlightenment, in better light.

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